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122647_EN

122647_EN

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Macro Commodities Forex Rates Equity Credit Derivatives
Please see important disclaimer and disclosures at the end of the document
27 March2013
Global Strategy
 Alternative view
www.sgresearch.com
Global Strategy
Weekly
The eurozone is working just fine
.as far as Germany is concerned
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
Global asset allocation
%
IndexIndexneutralSGWeight
Equities 30-80 60 30Bonds 20-50 35 50Cash 0-30 5 20
Source: SG Cross Asset Research
Global Strategy Team
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
 
In the wake of the Cyprus debacle,
 
I’m going to tackle the sensitive subject of eurozonebailouts. For me the increasing belligerence of creditors and debtors underlines why I thinkthe eurozone will ultimately break apart. Kicking the can down the road is not helping. Time isnot a healer - it is a killer. And what can we learn now from the fate of the East German MZmotorcycle?
 
We recognise that some readers don
t always like our frank analysis of economic andmarket conjunctures but we say what we see without fear or favour. Hence during theJapanese lost decade we repeatedly heaped derision on the incompetence of their policymakers who seemed to take every opportunity to snatch recession from the jaws ofrecovery. And during the mid-noughties we tried as hard as we could to get readers toshare our view, to little avail, that Alan Greenspan was totally incompetent.
 
We have chosen our words very carefully when analysing the eurozone conjuncture, butwe have been clear that we expect the eurozone to break apart. We will not repeat theargument yet again but only highlight that the deflationary wheel on which the peripheralcountries are being broken will in my view lead to increasing fractious relations betweenboth debtor and creditor nations. Debtors will keep missing deficit targets due to high fiscalmultipliers and creditors will have to repeatedly put their hands in their pockets.
 
Most economic analysis concludes, probably correctly, how much more costly it wouldbe for either a creditor or debtor nation to leave the eurozone system compared tostruggling on within it. Indeed for Germany, despite becoming increasingly irritated byhaving to dip their hands into their rapidly fraying pockets, the crisis in the eurozone hasbeen accompanied by the lowest unemployment rates since before re-unification in 1990(see chart below
we won
t rehearse the very valid argument that Germany enjoys anextreme currency undervaluation within the eurozone umbrella). For the German worker with5.3% unemployment it is a case of
crisis, what crisis?
But the argument about whether acountry will leave the eurozone will not ultimately be an economic decision. Leaving theeurozone will be a decision based on the politics of depression.
Where else is unemployment substantially below “Great Moderation” lows, other than in Germany?
Source: Datastream, Eurostat, (H/T Joe Weisenthal, Business Insider)
00 01 02 03 04 05 06 07 08 09 10 11 125678910111256789101112
GermanyFranceEurozone
 
Global Strategy Weekly 
27 March 20132
Ben Bernanke would be proud of the Troika (IMF, ECB and European Commission). The FedChair thought he was being reasonably successful in using QE to suppress yields and drivesavers out of cash deposits into riskier assets. The Troika in its dealings with Cyprus havegone one better. In the eurozone it is bank deposits that will now be considered by investorsto be the risky asset.The Troika have managed to exponentially increase concerns on how safe retail deposits arein the eurozone. It matters not that the final Cypriot bailout plan did not touch smaller saversunlike the original proposal of a 6¾% tax (haircut) for ALL deposits under
100,000 in ALLbanks (including foreign bank subsidiaries). The fact that this plan was originally sanctioned,despite deposit insurance, will have shaken small saver confidence to the bone. It certainlyhas shaken my confidence.I know from first-hand experience the extreme difficulty for a European citizen to open anaccount in another European country
it is nigh on impossible for the man in the street. If
JoeSixpack
in Spain or Italy or wherever is thinking the Troika are circling their country in thefuture, it is entirely rational, as Mervyn King suggests, to panic! (The Bank of EnglandGovernor, Mervyn King once said it was not rational to start a bank run but rational toparticipate in one once it has started.) But euro-Joe Sixpack is left with the choice of stuffinghis money under the mattress or buying
safe
financial assets (maybe overseas mutual fundsor gold?), or indeed spending the money on goods and services.The highly regarded commentator Gavyn Davies makes the point in the FT that
“althoughCyprus is tiny enough to be completely overlooked in most circumstances, its economy and  banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital  and reliance on foreign funding, is familiar territory in the eurozone.
Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis” 
 
see left-hand chart below.
Private sector credit (av 2008-2010, % of GDP) Banking Assets (end 2011, % of GDP)
Source: World Bank Source: Belgium Financial Sector Federation
Indeed I heard a very cogent defence of Cyprus
s position by Nobel prize-winning economistand my former economic lecturer, Christopher Pissarides, who heads Cyprus
s EconomicPolicy Council. His response to the criticism that the Cyprus economy was, like Iceland toodominated by banking was
what about Luxembourg?
Looking at the right-hand chart above,he may have a point!Part of the Troika
s explanation for forcing depositors to take a haircut as part of the bailoutwas that not to do so would have seen Cyprus
s public sector debt/GDP ratio rocket up by50%+. Indeed last summer all EMU leaders signed a pledge to break the
vicious cycle
 between banks and state insolvency. But as the UK
s Daily Telegraph correspondent, Ambrose Evans-Pritchard highlighted, this consensus was quickly broken as
an alliance ofhard-line creditors said the European Stability Mechanism (ESM)
or bail-out fund
could notbe used to cover
legacy assets
from past banking crises. Ambrose goes as far as to use theword
betrayal
to describe these events (see link ).
 
Global Strategy Weekly 
27 March 20133
 
So instead of recapitalising Cypriot banks directly via the ESM, the Troika ultimately foundanother, more traditional way to deal with the Cypriot banking insolvency
for that is what itis. And for someone like myself who cut their market teeth during the early 1990s US Savingsand Loan and banking crisis, my own view is that what has happened in Cyprus should havehappened to many other banks by now (especially in the UK). But the debate whetherinsolvent banks should be recapitalised by the taxpayer or liquidated, is undoubtedly asensitive one. And who decides if a bank is insolvent or merely having liquidity problems?These issues are dealt without much fuss in the US. The Federal Deposit InsuranceCorporation takes over
failed
US banks and wipes out creditors in order of seniority. Usuallyonce equity and bond holders are liquidated there are enough assets to repay uninsured inaddition to insured depositors (but not always). And if anyone looks at the list of banks takeninto receivership ( here ) and says that these are small regional banks, scroll down and look atSeptember 25 2008. In the immediate aftermath of the Lehman
s bankruptcy WashingtonMutual was seized after suffering a run amounting to almost 10% of deposits. At the time itwas the 6th largest bank in the US and became the largest bank failure in American financialhistory. It was done smoothly and efficiently without cost to the taxpayer. What for so long hasbeen normal in the US has clearly become the new normal in the eurozone.The Cyprus bailout has intensified anti-German sentiment around the periphery of Europe.This is, as Gideon Rachman points out in the FT yesterday, unfair. Yet a project specificallydesigned to avoid conflict within Europe has led to extreme hostility towards Berlin. Gideonbelieves this is partly because under President François Hollande,
“any notion that France is playing an equal role to Germany has disappeared. Over Cyprus, even the Finns seemed toweigh more heavily in the debate than the French.” 
 
 link.My final observation about the current eurozone conjuncture is to remind readers about thefate of the East German MZ motorcycle company (see picture below). Prior to the 1990reunification of Germany these motorcycles were an extremely common sight (eyesore?) onthe streets of London. But in what many saw as a cynical vote catching measure, ChancellorKohl allowed the East German savings in Ostmark deposits to be converted into theDeutschmark at a one-for-one exchange rate (the black market rate was nearer to 10-1). Theimmediate euphoria of East Germans being able to spend their savings at a favourableexchange rate was replaced by gloom as East German industry was bankrupted at this whollyincorrect exchange rate. The quaint, oily MZ had a market at the
 right 
exchange rate. At thewrong one East German industry was bankrupted and West German citizens were forced toultimately pay a heavy financial price for the resultant mass unemployment. And now all theseyears on one could say we are dealing with almost exactly the same issues: i.e. countrieslocked together at wholly inappropriate bilateral real exchange rates? Plus ça change
The East German MZ TS250 was a frequent sight on the UK roads until German reunification
Source: www.realclassic.co.uk/mz04092700

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